June 05, 2013

What are Swaps

What is the Open Interest for Swaps?

The buying and selling of financial assets has advanced with time into the highest dimensions with the wide variety of derivatives available. A swap is a derivative type used by an individual, organization or corporation to hedge its financial investment position. The number of "open interest swaps" tells the professionals a lot about the market sentiment for future price movements.

What are Swaps?

Swaps are the exchange of revenue streams (cash flows) of underlying assets. The most popular is the interest rate swap used to hedge a variable interest rate with a fixed interest rate. This is like an insurance policy protecting the holder against extreme price variations.

What is the Open Interest for Swaps?

High-frequency trading (HFT) has enabled professionals to buy-and-sell swaps in the matter of microseconds. More traders in the financial markets are settling their positions in less than 24 hours. These positions are closed when profits or losses are booked.

The "open interest for swaps" measures the number of open or unfulfilled swap contracts remaining after an exchange closes for the day. Firstly, an increasing number of open interest swaps suggests new money, demand or activity is entering the market.

Secondly, this overnight position means that the contract was not closed, settled or unwound. It is important to remember that open interest is not bullish or bearish; it is mostly about volume. An open interest swap means that the holder expects continued opportunities to make money in his financial investment.

How to Profit from Increasing Open Interest

A dramatic increase in the open interest for swaps suggests a new rumour, news story or economic report might lead to the modification of the value of the underlying asset. Professional investors expect a price movement. Others follow the bandwagon mentality and want to make money by following the market leaders.

Much of the derivatives markets are about anticipating future trends. When investors believe that trend will continue, they increase the open interest volume. When they believe a trend will revert to the mean, they close the derivatives to book their profits. When a contract is closed or unwound, then open interest decreases.

A trader can look at the open interest to determine market sentiment in his asset class. Open interest can tell him if he has an instant market for his option. Spreads should be tighter when open interest is high.

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